A Compensating Diffrentials Theory of Informal Labor Markets: Quantitative Model and Implications for a Developing Country

Abstract:

This paper develops a model of informal labor markets with search frictions, worker and firm heterogeneity, a comprehensive set of labor regulations, and explicit compliance decisions by workers and firms. Our implementation of intra-firm bargaining extends the literature by incorporating two sectors, firm heterogeneity, and minimum wages. In equilibrium, firms and workers self-select into the formal and informal sectors following a compensating differentials logic. The model does not resort to intrinsic differences across sectors and generates informality directly as a result of regulatory distortions, but it is still able to reproduce the stylized facts associated with informal labor markets. The quantitative model is used to shed light on the reduction of informality observed in Brazil between 2003 and 2012 and to assess the effectiveness of alternative policies aimed at reducing informality. In the model, a progressive payroll tax reduces informality and unemployment while increasing government revenues.